It is tough going for monetarists. Once you add financial institutions to your model, it turns out that quantitative easing hardly affects the quantity of money held by the non-financial sector at all, but is (effectively) an asset swap between the government and the financial sector, affecting the non-financial sector only via the channel of interest rates. Moreover, risk-free interest rates are low, households prefer to store marginal increments in wealth in the form of bonds rather than deposits, and central banks have given up on targeting monetary aggregates. The history of trying to manage the economy by managing the quantity of money has been a dismal failure predicated on not understanding how the financial institutions actually operate, or even what their primary mission is. It seems popular to view central banks as managers of aggregate demand, and ignore the trillions of dollars in income support payments flowing out of Treasury each year. However the first and foremost job of the central bank is to ensure a flexible money supply so that the its core constituency — banks — are able to convert illiquid collateral into money on demand. Any additional responsibilities are secondary, and can never interfere with this core mission, which is to make false the assumptions of the old school monetarist model. By ensuring that certain types of collateral are liquid — i.e. can be converted into money or used to borrow money — in all circumstances, the money supply becomes demand determined and is no longer a choice variable. And it cannot be a choice variable if we are to have a sound financial sector. The marginal cost of reserves is a choice variable. Bank regulation is a choice variable, collateral requirements are a choice variable, but the quantity of money is a state variable that is determined endogenously by the response of the private sector to these policies.
So why the obsession on market clearing and excess demand for money? Because the real problems faced by the economy are assumed away, and all that is left is a comical search for which market isn’t clearing. The markets are clearing just fine, nevertheless they are clearing in a way that provides less output and employment.
Economic Activity is not well modeled by an auction process
In an auction actors freely bid according to their preferences on a fixed set of endowments. Think of an estate sale. The endowments come from elsewhere.
The belief that, with full market clearing, real income is exogenously determined is responsible for our market fundamentalism.
You can only force production onto the Procrustean bed of an exchange process by assuming that production occurs in zero time. Only in that case can you model the firm hiring the worker and paying them with a portion of the worker’s output. The output must be available at the same instant that the worker is hired.
But capitalism is first and foremost about time — production requires non-zero time, and there is an ever greater lengthening of time from first input to final output. Microsoft spent years paying engineers to develop the next version of their office product. After those years of development, they then sold mass copies of this product, justifying the labor payments ex-post. But during those years of development, the workers were paid prior to the production process being complete, and with their payments, they purchased other products that were also produced in previous periods by other firms.
The capitalist process is not a process of exchange, but of investment. You make outlays in the present period without realizing a return on those outlays in the same period. The return occurs in subsequent periods. Fundamental to the investment decision is an expectation of the future price for which you will sell your output in relation to the present price with which you pay inputs.
It impossible for the investor to hedge that price. Therefore if prices are expected to decline, firms are less willing to pay to produce output today, because they are paying more, in real terms, today, for goods that will be available to be sold in the next period. The labor demand curve shifts to the left and output declines. When consumption prices are expected to increase, the real labor demand curve shifts to the right. When the ratio of capital goods prices to consumption goods prices is increasing, the labor demand curve shifts to the right, when this ratio is declining, the labor demand curve shifts to the left.
In no sense can you argue that output is exogenously determined — that the “endowments” are somehow independent of the expected time path of the price vectors. That is why you often hear of output gaps as “throwing output away” — they truly believe the output is there, even though no one is hired to produce it. What may be thrown away are opportunities, but not output. The production process is not an auction of exogenously set endowments.
You don’t need to hunt for snipe — for which market isn’t clearing — the markets are clearing with lower real incomes. An economy is not an estate-sale.
Now it is possible to concoct examples of economies in which real income is unchanged provided that all markets clear. For example, fruit ripening on a vine that requires no human input. Or backstrach economies in which production truly is instantaneous.
What these models have in common is that they deny the fundamental essence of a capitalist economy — of the production process as a risky process that cannot be hedged and that requires immediate payment in exchange for the possibility of future revenue in subsequent periods It is a leap-frog model in which, at any time, defection can cause real income to decline. Households pay to consume present goods with the income they receive from the production of goods that will be sold in the future. Such a model has equilibria in which output is below potential and yet all markets are clearing with perfectly flexible prices.
My view is that this, rather than the estate-sale model, is a more appropriate approach to understanding recessions and depressions. Things like downward nominal wage stickiness just aren’t important. If prices and wages were perfectly flexible then things would be as bad as they are now, at least to a first order approximation.